The Federal Reserve Could Have Done More to Improve the Economy

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President Obama took office in the midst of an economic crisis, and he's presided over three straight years of economic recovery. So why do the polls show that he is tied with an uninspiring Republican candidate, at a time when the GOP is relatively unpopular?

Perhaps it's because the economic recovery is strikingly feeble, by some indicators the weakest in American history. Indeed, we still have millions fewer jobs than in 2007, despite a population increase of nearly 15 million.

It's relatively easy to diagnose the source of our economic problems – deficient aggregate demand. When the economy suffers from supply-side problems, we get high inflation, as in the 1970s. Just the opposite is now true; we've had the lowest inflation since the 1950s in the four years since mid-2008 (when the recession became severe).

And here's what might surprise non-economists – this is not supposed to happen. For the past two decades, we've been imparting a model to our graduate students in economics that suggests the central bank has both the ability and responsibility to provide adequate levels of demand. One of the most prominent proponents of this model was none other than current Federal Reserve Chairman Ben Bernanke, who once claimed that the Great Depression was the Fed's fault, because it hadn't provided enough monetary stimulus.

So what went wrong? Were our models flawed, or did we fail to adopt the policies consistent with those models?

Many people assume that monetary policy is ineffective once interest rates hit zero. But that's certainly not the Fed's view. Bernanke has repeatedly emphasized that the Fed isn't out of ammunition; instead, he says, it's simply proceeding cautiously.

In July, Bernanke testified before Congress and told lawmakers that the Fed could do more to help the economy, and that it was considering whether it should. Then, in late August, the Fed Chairman described "the daunting economic challenges that confront our nation," particularly the labor market. Bernanke went on to suggest that the Fed could, and should, help fight unemployment – and he spoke in language that all but promised the central bank would act.

Despite Bernanke’s pronouncements, it’s not clear whether President Obama appreciates the importance of monetary stimulus. Obama has now appointed six of the seven members of the Fed Board, and yet he has failed to pick people who would aggressively promote the sort of stimulus that we need (and that he needs to assure re-election).

It's true that the Fed has deployed some unconventional stimulus, most notably two rounds of “quantitative easing (QE).” A third round was announced just a few weeks ago. Under “quantitative easing,” a central bank buys financial assets to inject a pre-determined quantity of money into the economy. This is different from the more usual policy of buying or selling government bonds to keep market interest rates at a specified target value.

But the effects of QE have been partially offset by a program of “interest on bank reserves” (adopted in 2008), which actually encourages banks to sit on the extra cash, and not push it out into the economy where it could do some good. In fact, the “interest on bank reserves” program has done very little to dilute caution among reluctant bankers, who say they don’t see enough creditworthy customers.

If we access history – and go back to 1999 – Ben Bernanke called on the Bank of Japan to show some “Rooseveltian Resolve” in its effort to get out of the zero-interest-rate trap and end deflation.

But as Fed chairman, Bernanke has warned of the vague and unspecified “costs and risks” of being more aggressive, even though all the actual risks in the U.S. and Europe are of sliding deeper into recession. And, to be sure, one of the reasons Europe is struggling today is because of monetary tightening – not loosening.

Until very recently Bernanke also failed to adopt a host of possible initiatives, some of which he recommended to the Japanese.

These include a lower interest rate on reserves, and much more aggressive and open-ended QE, with no fixed terminal date. A few weeks ago the Fed did finally announce a more aggressive QE program, which will be continued until certain unspecified inflation and employment benchmarks are hit. One important advantage of QE over fiscal stimulus is that it doesn’t add to the budget deficit.

But the most effective tool at Bernanke’s disposal might be “level targeting,” which calls for the Fed to make up for any undershooting of its inflation target. Because inflation has averaged only 1.2 percent since mid-2008, the central bank has plenty of room for stimulus before overshooting a 2 percent trend line for inflation.

And yet, despite their positive potential, the Fed has refused to use its most effective policy tools.

There is a vigorous debate within the economics community about whether the Fed should do more to revive the economy.

For the most part, the political establishment doesn’t even know this debate is occurring. It assumes that the Fed is doing all it can. If it knew the truth – that the Fed could provide much more stimulus without any increase in the budget deficit – it would almost certainly be shocked by its passivity.